ECONOMICS OF THE GATT/WTO

Transcription

1 ECONOMICS OF THE GATT/WTO So if our theories really held say, there ould be no need for trade treaties: global free trade ould emerge spontaneously from the unrestricted pursuit of national interest (Krugman, 1997) Why then in trade negotiations does a government require a concession from its trading partner(s) in order to do hat is in any event best for its country? (Bagell and Staiger, 1999) Observation that governments seek reciprocity in trade agreements often interpreted to mean trade negotiators are adopting a mercantilist perspective inconsistent ith economic logic Krugman (1991) observes that there are three simple rules about the objectives of negotiating countries: - exports are good - imports are bad - ceteris paribus, an equal increase in imports and exports is good GATT-think is enlightened mercantilism, i.e., it is mercantilist in presuming countries unilaterally like to subsidize exports and tax imports, and enlightened in recognizing this could be destructive

2 GATT-think then sees the trade policy problem as Prisoners Dilemma individually, countries have an incentive to be protectionist, yet collectively they gain from free trade Hoever, if this is so rong from an economic perspective, ho is it that in fact GATT-think has turned out mostly right? What is its hidden logic? (i) Based on political pressure argument, government policy does not necessarily represent public interest, but rather small ell-organized groups such as exporters and import-competing producers hich explains first to principles of GATT-think (ii) Despite ignoring gains from trade as economists understand them, in setting exporter interests as a counter-eight to import-competing interests, and by bargaining for access to each others markets, trade negotiators do move system closer to free trade Since 1947, through 8 rounds of GATT, average ad valorem tariffs have fallen from over 40 percent to less than 4 percent, and membership of GATT/WTO has gone from 23 to 153 countries Bagell and Staiger (1999), hoever, sho that there is a basic economic logic for GATT/WTO. They start ith a very basic question hat do governments gain from a trade agreement?

3 Essentially, there is an inefficiency governments ish to remove by being in a trade agreement - the inefficiency being terms of trade externalities of unilateral trade policies, i.e., imposition of an import tariff may drive don orld price, imposing costs on exporters Key pillars of GATT are principles of reciprocity and non-discrimination: (i) Reciprocity principle by hich one country agrees to reduce level of protection in return for a reciprocal concession from trading partner (ii) Non-discrimination concession given to one trading partner is given to all other trading partners Do these principles serve as simple rules of negotiation that promote efficiency? Model: (i) Economic environment 2-countries, home and foreign (*), 2-goods, x and y produced competitively under increasing costs, x (y) being natural import good of home (foreign) country Home local relative prices are denoted as p p / p = τ p p(τ, p ), and foreign local relative x y * * * * * * prices are p p / p = p / τ p (τ, p ) x y

4 p p * / p is orld relative price, τ and τ * being home x y and foreign ad valorem tariffs/subsidies, τ (τ * ) > 1 for an import tariff and τ (τ * ) < 1 for an import subsidy Production in each country is a function of local relative prices, Q = Q ( p ) and Q * = Q * ( p * ) fori { x, y }, hile i i i consumption is a function of local relative prices and tariff revenue R(R*), hich is distributed as a lumpsum to home (foreign) consumers Home and foreign consumption are respectively D = D ( p,r ) and i i i D = D ( p, R ) fori { x, y }, ith * * * * i i home tariff revenue being defined implicitly as R = [ D ( p,r) - Q ( p)][ p - p ], R = R( p, p ), and also x x foreign tariff revenue being defined as * * * * * * * * * * R = [ D ( p,r ) - Q ( p )][1 / p -1 / p ], R = R ( p, p ) y Consumption then becomes and y C ( p, p ) D ( p,r( p, p )) * * * * * * C ( p, p ) D ( p, R ( p, p )), ith home imports of x being i exports of y being i i M ( p, p ) C ( p, p ) - Q ( p ), and home x x x E ( p, p ) Q ( p) - C ( p, p ), ith y y y similar expressions for foreign country imports of y, M y * and exports of x, E x * Home and foreign budget constraints imply that, for any orld price, trade balances: i

5 (1) p M ( p(τ, p ), p ) = E ( p(τ, p ), p ) x M p p p p E p p p * * * * * * y( (τ, ), ) = x( (τ, ), ) * the orld equilibrium price p ( ττ, ) being determined by the y-market clearing condition * * * (2) E y( p(τ, p ), p ) = M y( p (τ, p ), p ) market-clearing for x being determined by (1) and (2) Given an initial pair of tariffs, (2) determines orld price, hich along ith tariffs then determines local prices, thereby implying production, consumption, imports, exports and tariff revenue Also, in order to avoid the Lerner and Metzler paradoxes, impose conditions p / τ < 0 < p / τ * (ii) Government objectives y * * dp / dτ > 0 > dp / dτ and Objectives of home and foreign governments are given as W ( p(τ, p ), p ) and * * * ( (τ, W p p ), p ), and holding local price fixed, each government achieves higher elfare hen its terms of trade improve: * * (3) W ( p, p ) / p ) < 0, and W ( p, p ) / p ) > 0

6 * Figure 1 illustrates initial tariff pair at A (τ, τ ), hich is associated ith a domestic iso-local price locus p(a) p(a), and an iso-orld price locus p (A) p (A) A second iso-orld price locus is given by p (C) p (C), along hich orld price is loer than at A, implying improved terms of trade for home country, i.e., a reduction in orld price that maintains home price is achieved ith a move from A to B, given higher (loer) home (foreign) tariff Implied income transfer of A to B only valued by home country representation of government preferences general enough to include maximization of national income (Johnson, 1953/54), as ell as distributional objectives (Hillman, 1982; Grossman and Helpman, 1994; 1995) (iii) Purpose of reciprocal trade agreements Assume governments ant to participate in reciprocal trade agreements in order to achieve mutually beneficial changes in trade policy a Pareto improvement, as measured by W and W *, over hat ould be achieved through unilateral tariff setting Reciprocal trade liberalization is mutual reductions in tariffs, and if an efficient reciprocal trade agreement is reached, it ill be on a locus defined by:

7 Figure 1: World- and Local-Price Effects of Tariff Change τ p(c) p (C) p(a) p (A) τ' C B p (C) p(c) τ p (A) A p(a) τ* τ*

8 (4) [ dτ / dτ * ] = [ dτ / d τ * ] * dw =0 dw =0 In absence of reciprocal trade agreement, hat ill be inefficiencies? Each government sets trade policy to maximize objective function, given tariff choice of other country, resulting reaction functions being: (5a) Home : W [ dp / dτ]+ W [ p / τ] = 0 p * * * * * (5b) Foreign : W [ dp / dτ ]+ W [ p / τ ] = 0 p* p Where subscripts are partial derivatives, and ith * λ [ p / τ]/ [ dp / d τ] < 0, [ p / τ * ]/[ dp * / dτ * ] < 0, (5a) and (5b) can be re-ritten as: (6a) Home : W + λ W = 0 p p * * (6b) Foreign : W + λ W = 0 p p* p Best-response tariff for each government determined by impact local- and orld-price movements have on elfare At * A (τ,τ ) in Figure 1, holding τ * constant, if home tariff raised to τ', a ne tariff pair at C (τ 1,τ * ) is induced, hich lies on ne iso-local price locus p(c) p(c), and a ne iso-orld price locus p (C) p (C)

9 Home government induces higher local price and loer orld price, move from A to C being the combination of: (i) A to B, change in orld price, from 6(a) given by λw, hich is strictly positive by (3) p (ii) B to C, induced increase in local price, hich is W p Nash equilibrium tariffs N * N (τ,τ ) are those that satisfy (6a) and 6(b). A Pareto improvement can be achieved through reciprocal trade agreement characterized by reciprocal trade liberalization Proposition 1: Nash equilibrium tariffs are inefficient Proposition 2: A reciprocal trade agreement must entail reciprocal trade liberalization Terms of trade externality implies government faces less than full cost of imposing tariff, so they oversupply protection relative to efficient levels given preferences - externality is only inefficiency a reciprocal trade agreement can remedy

10 Consider a orld here government does not value terms of trade effects of unilateral tariff choices, politically-optimal tariffs being defined as (τ PO,τ *PO ), that simultaneously satisfies: (7a) Home : W = 0 p * (7b) Foreign : W = 0 p* Where each government aims to maximize national income, politically optimal tariffs correspond to reciprocal free trade Proposition 3: Politically optimal tariffs are efficient From Figure 1, home government considers domestic costs and benefits of a tariff increase through (i) increase in domestic price (B to C), and (ii) extent to hich costs are shifted onto its trading partner through fall in orld price (A to B) In hypothetical case here government does not value (ii), only motivated by (i) if both governments behave this ay, politically optimal tariffs are efficient Politically optimal tariffs not only efficient tariffs use (4) to re-rite efficiency locus as: (8) (1- AW )(1- AW * * ) = 1 p p*

11 * * * * * A (1- τλ) / ( W + λw ) and A (1- λ / τ ) / ( W + λ W ), p p p* p * A 0, and A 0 under assumption elfare functions are finite (8) satisfied hen W p =0 and W p * =0, so that politicallyoptimal tariffs are efficient, but (8) also satisfied if W p 0 and W p * 0 Starting from political optimum, other points on (8) can be reached by altering tariffs to generate local prices that are efficient given ne distribution of orld income implied by associated orld-price movements Assume that: (i) a unique Nash equilibrium exists; (ii) a unique political optimum exists; and (iii) political optimum lies on contract curve point on efficiency locus yielding mutual gains to each government, relative to Nash elfare In Figure 2, from Proposition 1, Nash tariffs (N) lie off efficiency locus (8), E E; from Proposition 2, relative to N, trade agreement can increase elfare of both governments ith reduction in both tariffs; from Proposition 3, politically optimal tariffs PO lie on EE, iso-elfare curves being tangent along locus Note at politically-optimal point, iso-elfare curves also tangent to iso-orld price locus

12 Figure 2: Purpose of a Reciprocal Trade Agreement τ E W N N p po PO W* N E τ *

13 Reciprocal trade agreement allos governments to cooperate and replace higher Nash tariffs ith tariffs on contract curve. Ho is trade agreement to be designed rules-based vs. poer-based? GATT based on a rules-based approach reciprocity and non-discrimination Reciprocity: (i) Principle of Reciprocity Mutual changes in trade policy generating equal changes in import volumes across trading partners 1 0 * *1 *0 Tariff changes Δτ (τ - τ ) and Δτ (τ - τ ) conform to principle of reciprocity, provided: p [ M ( p(τ, p ), p ) - M ( p(τ, p ), p ) x x * * *1 1 1 * * *0 0 0 = [ M ( p (τ, p ), p ) - M ( p (τ, p ), p )] y y 0 here 0 *0 1 p p (τ,τ ), p p (τ 1,τ *1 ), and changes in import volumes measured at orld prices Using (1) and (2), expression reduces to: [ p 1 - p 0 ] M ( p(τ, p ), p ) = 0 x i.e., mutual changes in trade policy conforming to reciprocity leave orld prices unchanged

14 Unilateral tariff choices inefficient if governments motivated by ability to change orld price under reciprocity, terms of trade externality neutralized, as mutual tariff changes leave orld price fixed (ii) Reciprocity and Balance of Concessions Notion of reciprocity embedded in GATT Article XXVIII although governments typically seek a balance of concessions as noted earlier, seems to defy economic logic Bagell and Staiger (1999) argue informal principle of reciprocity characterizing actual trade negotiations admits a straightforard economic interpretation Proposition 4: Starting at Nash equilibrium, reciprocal trade liberalization conforming to reciprocity increases each government s elfare monotonically until point here * min[- W, W ] = 0. If countries are symmetric, p p* liberalization leads to politically optimal outcome At Nash equilibrium, each government prefers more trade, but it ould like to achieve this ithout, terms of trade loss. From (3) and (6a), W p <0 at Nash equilibrium, so domestic price is higher than government ould like, given Nash orld price

15 Home government ould like to reduce tariff, loer domestic price and experience increase in trade volume, if it could ithout reducing terms of trade Negotiated mutual reduction in tariffs that conforms to reciprocity generates higher trade volume ithout terms of trade loss both governments benefit from tariff reductions, as long as trade liberalization does not * go beyond point at hichmin[- W, W ] = 0, i.e., here p p* one government obtains preferred local price given initial Nash orld price Figures 3A and 3B illustrate Proposition 4 for case of symmetric and asymmetric countries: (i) (ii) In Figure 3A, iso-orld price locus that runs through N also intersects at PO here both governments simultaneously achieve locallypreferred prices at politically optimal tariffs In Figure 3B, Nash iso-orld price locus does not intersect PO, mutual benefits from liberalization terminating before EE is reached i.e., at Z, home government achieves preferred local price Reciprocity induces governments to act as if they do not value terms of trade movements associated ith unilateral tariff selections, i.e., orld price is fixed, and preferred tariff satisfies W p =0

16 τ Figure 3A: Liberalization and Reciprocity - Symmetric Case E p (N) N p (N) W W* PO E τ p po Figure 3B: Liberalization and Reciprocity - Asymmetric Case E p po p (N) W* W PO W Z N τ * p (N) E τ *

17 Looking at (6a), home government s preferred tariff satisfies W p =0 hen term λ W = 0 - this is true if government either does not value a change in terms of trade, W 0, or it expects a reciprocal tariff p adjustment from foreign country, resulting in no change in terms of trade, λ=0 Returning to Krugman s (1991) rules of enlightened mercantilism, Propositions 1-4 provide a formal interpretation of them: - exports are good - reduction in import tariff levied by foreign country improves terms of trade - imports are bad - concession implies reducing import tariff resulting in terms of trade decline - an equal increase in imports and exports is good balance of concessions serves to neutralize terms of trade decline that make unilateral trade liberalization undesirable (iii) Reciprocity and Renegotiation: Other application of reciprocity in GATT is ho a country can renegotiate a previous agreement under GATT Article XXVIII, country may propose to modify/ithdra a tariff concession, and partners are then able to ithdra substantially equivalent concessions p

18 Bilateral negotiation game: - Stage 1: Governments bargain over tariffs and a orld price, p, is determined - Stage 2: Home government proposes domestic tariff, ˆτ at same time as foreign government offers a foreign tariff ofτ ˆ *. If proposals agree, implemented as outcome of negotiation - Stage 3: If proposals do not agree, tariffs implemented are those that achieve greatest trade volume hile satisfying restrictions of reciprocity and proposed imports First determine tariffs that can be achieved under reciprocity in stages 2 and 3, and then describe stage 1 bargaining process In Figure 4, there are three pairs of efficient tariffs, A, B, and PO, along ith associated orld price-loci. Also sho loci representing tariffs for hich W p =0 and W * p * =0 - by (8), each intersects efficiency frontier EE at PO and nohere else Suppose initial agreement is at A foreign government prefers to move to A' here it achieves preferred local price, so it has incentive to propose τ * (A'), ith implied domestic tariff of τ(a')

19 Figure 4: Renegotiation under Reciprocity τ E A' p (A) W* p po p (A) p po A W W* PO p (B) W B' B W* p* =0 E p (B) W p =0 τ *

20 This is a dominant strategy for foreign government, i.e. A is not renegotiation proof under GATT rules. Apparent too that B also fails the renegotiation test, this time the home government ithdraing original concession to induce B' Only one efficient tariff pair, if agreed to initially, that is impervious to renegotiation the politically optimal pair, hich is only point on EE at hich each government gets its preferred local price for given orld price Tariff pair (τ,τ * ) can be implemented under reciprocity if there is a orld price p such that outcome of stages 2 and 3 of bilateral negotiation game is uniquely (τ,τ * ) hen governments make dominant proposals Proposition 5: An efficient trade agreement can be implemented under reciprocity if and only if characterized by tariffs set at politically optimal levels i.e., if governments recognize potential for renegotiation under GATT rules, and if they seek efficient outcome, negotiations ill result in politically optimal tariffs

21 In Figure 5A, locus of tariffs implementable under reciprocity in a reciprocal trade agreement corresponds to upper envelope of portions of W p =0 and W * p*=0 loci that lie inside Nash elfare contours of governments, i.e., R PO R Figure 5B shos information in elfare space, W (W*) on the axes and N at origin. Dashed curve is efficiency frontier, hile bold curve corresponds to R PO R this shrinks feasible set of bargaining outcomes to lie inside frontier, except at PO Constraint of reciprocity has effect of steering stage 1 bargaining game toards political optimum, i.e., limits extent to hich one government can gain at other s expense relative to PO Suppose governments bargain only over final tariffs ith no possibility of renegotiation, feasible set of outcomes is dotted frontier in Figure 5B, and bargaining outcome ould be say at A Instead suppose the bilateral negotiation game is in place, feasible set is bold frontier in Figure 5B, solution no being B, here stage 1 bargaining is no closer to political optimum

22 Figure 5A: Locus of Tariffs under Reciprocity τ E W N N W p =0 R p po W* N R PO W* p* =0 E W Figure 5: Feasible Bargaining Set under Reciprocity A τ * B PO N W*

23 Non-Discrimination and Reciprocity: Principle of non-discrimination as embodied in mostfavored nation (MFN) clause, is second pillar of GATT Bagell and Staiger (1999) extend their setting to a multi-country frameork to assess role of nondiscrimination in multilateral trade agreements Home government elfare function no embodies a novel pattern of externalities if it adopts discriminatory tariffs: (i) (ii) Tariff selected by foreign government alters orld prices, affecting home country s terms of trade, and imparts an externality via tariff revenue Tariff selected by foreign government may exert a home country externality through effect tariff has on foreign local price, and thereby home country s terms of trade and tariff revenue Imagine home country sets a higher tariff on imports from foreign country 1 it is no affected by composition of trade volume across countries Ceteris paribus prefers more trade volume ith country 1, but exports shares of n foreign countries also partly depend on their local prices, and therefore, they impart an externality hen home tariffs are discriminatory

24 Local price externality disappears hen home government s tariffs satisfy MFN, terms of trade being affected only by common orld price Proposition 6: Politically optimal tariffs are efficient if and only if they conform to MFN i.e., politically optimal tariffs are efficient provided externalities countries impose on each other in their tariff choices travel only through orld prices Proposition 7: An efficient multilateral trade agreement can be implemented under reciprocity only if characterized by tariffs conforming to MFN and set at politically optimal levels Non-discrimination ensures all externalities travel through orld prices, and principle of reciprocity serves to neutralize such externalities If Stage-1 bargaining results in discriminatory tariffs, tariff choices impart both orld-price and foreign-price externalities, reciprocity being ill-suited to handle the latter

25 Reciprocity and non-discrimination hen used together can generate an efficient outcome: (i) (ii) Non-discrimination/MFN ensures a single orld price, and home government no longer has direct interest in composition of trade volume elfare no longer affected by foreign local prices Reciprocity ensures single orld price stays fixed Preferential Trade Agreements: A major exception to the tin pillars of GATT is embodied in GATT Article XXIV alloing creation of preferential trade agreements such as free-trade areas (NAFTA) and customs unions (EU) As free-trade areas are inherently discriminatory, an implication of Proposition 7 is: Proposition 8: An efficient multilateral trade agreement cannot be implemented under reciprocity in presence of free-trade agreement Follos from fact that members of free trade area maintain discriminatory tariffs against non-members of free-trade area, so externalities pass through local as ell as orld prices

26 With a customs union, members should eliminate all internal trade barriers as ell as adopting a common external tariff, consequently, an additional implication of Proposition 7 is: Proposition 9: An efficient multilateral trade agreement can be implemented ith reciprocity and a customs union, if members of customs union are internally integrated, and its external tariffs, along ith tariffs of all other countries, conform to MFN and are set at politically optimal levels